ECB's Draghi faces leadership test over euro pledge

August 01, 2012|Reuters

By Sakari Suoninen

FRANKFURT, Aug 2 (Reuters) - European Central Bank PresidentMario Draghi faces intense pressure from investors, Europeanleaders and even the United States to deliver on Thursday on hispledge to do whatever it takes to save the euro.

Draghi will face the biggest test of his nine months'leadership of the central bank when it meets later in the day,and any signs that he overplayed his hand when making the pledgea week ago could see markets punish the euro zone.

The ECB has little margin for error to maintain itscredibility and avoid bond yields climbing in the indebtedcountries on the euro zone periphery.

The market's faith in Draghi will be tested before the 1230GMT post-meeting press conference by a Spanish bond auction thatcould see its debt costs rise.

"Draghi has unfortunately painted himself into a corner," JPMorgan analyst Pavan Wadhwa said in a conference call.

"The ECB does need to demonstrate its credibility ...Otherwise Draghi will lose face completely."

While central bank sources have told Reuters that boldaction is probably at least five weeks away, Draghi may offersome clues on what is in the offing. He said last Thursday thatthe political capital invested in the euro is oftenunderestimated.

"Within our mandate, the ECB is ready to do whatever ittakes to preserve the euro. And believe me, it will be enough,"Draghi told an investment conference in London.

Spanish and Italian bond yields fell markedly after Draghi'sspeech, and inaction could send them higher again.

"We could see markets going back to where they were beforelast Thursday," said Nordea analyst Anders Svendsen, who expectsmore words but little concrete action from the meeting.

Other countries, especially the United States, have soughtto raise pressure on the ECB to act. U.S. Treasury SecretaryTimothy Geithner said the euro zone must take steps to bringdown borrowing costs in troubled member states.

GERMAN DISSENT

The ECB has already bought bonds through its SovereignMarkets Programme (SMP), spending more than 210 billion euros onthem so far, and re-employing an existing tool would avoid thelegal battles that any novel measures could face.

While the SMP is widely viewed as having had very limitedsuccess, it is at least available immediately and could be usedin a new form, combining it with the EFSF bailout fund.

The ECB could use the SMP to buy bonds after Spain makes aformal request to the EFSF and also commits to reforms.

"Based on Draghi's comments a restart of SMP (or EFSF/ESM)buying appears the most likely response," Danske Bank's Allanvon Mehren and Anders Moller Lumholtz said in a note.

ECB action is hamstrung by EU rules forbidding it to financegovernments. The ECB issued a legal opinion in March 2011 rulingout perhaps the biggest gun, giving the ESM bailout fund rightsto tap the ECB for funds to increase its firepower.

Draghi himself has argued against the move, but last weekGoverning Council member Ewald Nowotny broke ranks and said itcould be advantageous to give the ESM a banking licence thatwould allow it to borrow. Some ECB watchers believe the move wasa trial balloon sent up in coordination with the ECB leadership.

The ECB also has to find a way to get any measures pastGermany, the euro zone's largest economy and its principalpaymaster. The Bundesbank issues regular reminders ofinflationary dangers stemming from non-standard measures such asbond purchases and the limits central banks face.

On Wednesday, the German central bank released an interviewwith Bundesbank President Jens Weidmann, where he said that"politicians overestimate the central bank's capacity and placetoo many demands of it".

The dilemma for Europe is that too little action now couldcreate bigger problems later. If borrowing costs don't comedown, forcing both Spain and Italy to seek aid, the ESM's 500billion euro capacity would soon be depleted, and it would needmore funds.

"I think that's a bridge that doesn't need to be crossedyet," JP Morgan economist David Mackie said in a conferencecall.

NO RATE CUT EXPECTED

Another tool at the ECB's disposal, lowering interest rates,is unlikely to be used again so soon after it cut its mainrefinancing rate to a record low of 0.75 percent in July. AReuters poll showed that economists see another decrease ininterest rates before the end of the year, but only seven out of70 expected it to cut again this month.

As the crisis has intensified, the euro has taken a hit inforeign exchange markets. It has fallen about 15 percent in thepast year to trade at $1.23. On a trade-weighed basis it tradesat nine-year lows.

The falling euro is likely to delay the day when inflationfalls below the ECB's target of 2 percent. In July, it remainedat 2.4 percent. It also assuages fears of deflation, however, aspectre that could otherwise have prompted the ECB to considerlarge-scale bond buying.

"To move into large-scale asset purchases from purelymonetary stance motivation will take a while," J.P. Morgan'sMackie said. "It's certainly not going to happen ... until weget into next year."